The Millionaire Next Door: On Spending

The Millionaire Next DoorThis week, Money360 is conducting a detailed review of the often-lauded personal finance book The Millionaire Next Door. First published in 1996, the book has held a consistently high level of popularity for more than a decade. What valuable insights does this book contain? By the end of the week, perhaps we’ll discover its secrets.

Yesterday, we learned that the main premise of The Millionaire Next Door is to profile actual millionaires and what they have in common, and we discovered that they aren’t what we think of when we think of millionaires. The early chapters of this book really focus on defining this profile of a typical American millionaire, and it turns out that they’re actually very thrifty. The early chapters do a solid job of exposing the pop culture concept of a millionaire – that of the wild spender with an extravagant home and material goods – as just that: a construct of popular culture.

This concept is perhaps best explained by a portion of the second chapter which describes four questions to which the answers determine whether you’re living a wealth-building lifestyle or expending your wealth maintaining your lifestyle:
1. Does your household operate on an annual budget?
2. Do you know how much your family spends each year on food, clothing, and shelter?
3. Do you have a clearly defined set of daily, weekly, monthly, yearly, and long-term goals?
4. Do you spend a lot of time planning your financial future?

Unsurprisingly, the more “yes” answers that people give to the above questions, the more likely they are to have established significant personal wealth. For me, these questions were somewhat comforting, as I am now able to answer these questions with three strong “yes” answers and a “mostly” answer (the budget one is still in process), which compared to the four “no” answers that I would have delivered a month ago indicates that I’m psychologically improving my financial state.

The most powerful point (for me) was the strong correlation between time spent planning and considering personal finance and the actual presence of wealth. The extensive surveying that provides the backbone for this book repeatedly shows a direct relationship between attention to financial planning and accumulation of personal wealth. The people described in this book as prodigous accumulators of wealth generally invested the time in assembling highly detailed budgets and mechanisms for tracking their spending, while the underaccumulators did not invest the time.

The first chapters did expose a major flaw in the book, though: The Millionaire Next Door has a strong anti-youth bias. Early in the book, the authors define a simple rule of thumb for estimating one’s net worth: multiply your age times your realized pretax annual household income from all non-inherited sources and divide by ten. Go on, do it yourself.

When I did this, I was shocked as to what the formula expected as a net worth for me: over a quarter of a million dollars. I’ve only been in the workforce for four years and I have a big pile of student loan debts, so I’ve worked hard to manage to just recently achieve a positive net worth. I’m not alone in this situation – many younger people have had to take on substantial amounts of debt in order to finish school, so only a very lucky or a very exceptional person under the age of thirty five could come anywhere close to matching this rule of thumb. Of course, when you hit your stride in your late forties and fifties, it’s a solid rule of thumb, but the formula is simply not realistic for many younger people today.

Another way that the book exposes this anti-youth bias is via another interesting metric: evaluating your income tax paid as a percentage of your net worth. Now, for youth with student loans, the percentage is likely going to be quite large, but the book says that one should strive for a number approaching 7% (or even lower, if possible). For me, my income tax paid as a percentage of my net worth is probably going to be over 100% this year, and in years past it was infinite (as my net worth was negative). This is a great metric to define your progress in your forties and fifties, but for younger people, it’s a metric that paints an overly critical picture of our financial shape.

In short, the book often ignores the sacrifices youth make early in their life in order to maximize their earning power later. The reason for this bias is in their sampling: everyone interviewed in the book is already well into middle age. They focused on the people that have already had many years to either accumulate wealth or put themselves in a position where their income is barely able to cover their lifestyle while largely ignoring the people early on who have to make sacrifices to allow themselves to be able to make such choices at all. For a younger reader such as me, this book often feels like a peek ahead at issues I’ll be concerned with in ten years; it’s nice for long-term thinking, but not as useful in preparing my finances now for financial accumulation while managing young children and a first home purchase.

In the next part of this five part series reviewing The Millionaire Next Door, we’ll tackle the next three chapters of the book in detail, in which we find out how millionaires learned what they know and how they impart it on others.

You can jump quickly to the other parts of this review of The Millionaire Next Door using these links:
On Spending
On Learning
On Living
Buy or Don’t Buy?

The Millionaire Next Door is the first of fifty-two books in Money360’s series 52 Personal Finance Books in 52 Weeks.

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